Believe those who are seeking the truth. Doubt those who find it.Andre Gide

Sunday, June 24, 2012

NGDP Targeting in an OLG Model (Another Try)

I would like to follow up on my earlier post: NGDP Targeting in an OLG Model. The purpose of that post was to evaluate the desirability of an NGDP target policy within the context of an explicit (mathematical) macroeconomic model. Josh Hendrickson does a good job of explaining the motivation behind my approach here (and btw, thank you for the kind words, Josh.) Josh goes on to provide a list of reasons for why an NGDP target is a good policy prescription, but he does not really address the point I was trying to make with my simple model. And so, let me try again, this time in less technical terms.

First, let me describe the model economy I employed in my earlier post. The economy is populated by different types of people. At any point in time, there are people with relatively large wealth positions and high consumption propensities--and there are people with relatively small wealth positions who have high saving propensities. This is not a "representative agent" model economy: people are different--and these differences matter.

There are two types of assets in the economy, that I label "capital" and "money" (or government debt). I model capital as physical capital, but it should be clear that one may substitute any form of private investment in its place, including human capital investment, or recruiting investment (as would be the case for a labor-market search model). Capital investment is just a metaphor for any activity involving a sacrifice today for an uncertain return reward in the future. In the model, peoples' perceptions of this future reward (whether such perceptions are rational or not) are a key driver of investment demand (and hence, aggregate demand). Does this sound crazy? (I don't think so.)

The government money/debt plays an important role in this model economy. In particular, the competitive equilibrium turns out to be inefficient without it (there is a dynamic inefficiency). Of course, this does not mean that the government can print paper haphazardly. From a social welfare perspective, it will want to manage the supply of its paper in a particular way (that I will describe below).

There is a "sticky" nominal price in the economy: the nominal interest rate on government paper cannot be made contingent on any contemporaneous information (in particular, the expectations shocks that afflict investment demand). I imagine that one could also include nominal private debt (like mortgage debt), but it would not affect the qualitative results I report below. All other prices are flexible.

Now, let me describe how this economy behaves over time, assuming a "passive" government policy of keep the nominal supply of debt fixed.

There are two types of shocks: (1) a news-shock that affects investment demand (and so looks like an AD shock), and (2) a productivity shock that affects the ex post return on capital (and so looks like an AS shock).

Good news creates a rational optimism: investors revise upward their forecast over future returns to capital investment. Agents "dump" money/bonds and substitute in private securities. The money dump results in a surprise jump in the price-level. The real value of outstanding government debt declines. There is a redistribution of wealth from bondholders to investors.

The opposite happens when the news is bad (a productivity slowdown?). A sequence of bad news shocks results in a deflation. Capital spending contracts, and with it, future GDP. There is a redistribution of purchasing power away from investors toward bondholders that further depresses investment spending.

I claim that qualitatively, this model generates dynamics that most people would have a hard time distinguishing from the data.

The optimal policy here turns out to be a price-level target (PLT). The role of the PLT here is to prevent variation in the real value of nominal debt that is not indexed to the price-level. Ex ante, agents want to avoid transfers of wealth stemming from uninsurable price-level shocks interacting with nominal debt.

So, if the news is bad, the government should increase the supply of money to accommodate the increase in demand for money (via the asset substitution induced by bad news over the expected return to investment). But if the news truly is fundamentally bad, the future real GDP should decline, and along with it, the NGDP should decline as well (it's decline is stemmed in part by maintaining the price level target). Stabilizing the NGDP in this context would mean increasing the price-level so high as to create a transfer of wealth from creditors to debtors (instead of debtors to creditors) --something these agents would have wanted to prevent ex ante if nominal debt could have been indexed to the price-level.

This was the gist of my argument. I was just curious to see what NGDP targeting advocates thought of it. What is missing in my model? Are frictions other than nominal debt required? I have a hard time seeing how the presence of sticky nominal wages or prices are going to alter my conclusion here. But who knows, maybe someone can tell me?

Note: If the expectation shocks I describe above are not rational (e.g., possibly psychological "animal spirits"), then obviously there is a role for NGDP (and RGDP) targeting. However, I don't really hear Scott Sumner and others making this claim (or do they?).

60 comments:

I wonder how community bankers would react to your "model" of how investments are made?

According to the data and literature, a very substantial part of the continuing and ongoing "shock" to investment in the economy is the 40% decline in housing value.

Formerly, this "asset" was the basis for community bank lending to small business. Banks use seconds on real property at appraised value to support extensions of credit for investment in new business. That source of credit, and accompanying investment, is now gone.

This is one reason why I am skeptical of NDGP; as per a prior comment, I believe we knew what we were doing in the 1978 era of macro, but no longer.

A second reason I remain skeptical is that I do not see anyone discussing how one matches expectations to the targets.

We have so destroyed confidence that the targets being talked about will not restore confidence, for they will not restore the missing 40% in avg. family wealth.

Last, NGDP does nothing about "sticky" profits.

It seems to me that we should be hearing from people like Cochrane on the necessary implication of current high profits. That business in the US is crony capitalism and oligarchy, protected from competition.

Given high profits and low interest rates, why aren't competitors entering markets, cutting into profits to bring them more in line with bond yields? What are the barriers to entry?

Last, regarding rationality, doesn't the range of movement of a 10 or 15 year moving average of any broad stock index show that all decisions are irrational, as all decisions are based on guesses based on incomplete information including guesses about what others will do now and in the future?

Im sum, it seems to me that the solutions being put forward tend to show that macro is a man with a hammer when the world is not a nail.

Bernanke has used the tools available to assure that the stock market has recovered (it is an open question being whether he can keep this gain).

Bernanke has not, however, nor has macro, put any effort into restoring the financial position of the avg. American whose wealth was not in the stock market.

Thus, in the end, I would argue that there are two issues?

First, would NGCP postively impact confidence? No, not until we get real and very substantial transfers of wealth back to debtors (the avg. American is a debtor).

Second, would NGDP restore the lost 40% to the avg. American? No.

In sum, and I just read the news reports about Merkel saying "No," to France, I remain in the school that we have learned nothing since the 1930s.

The NGDP argument is not about good economics, it is about social proof and other pyschological limitations on the minds of macro.

Stiglitz has been sayig it for sometime. Krugman has now said it, bluntly:

"But ultimately the deep problem isn’t about personalities or individual leadership, it’s about the nation as a whole. Something has gone very wrong with America, not just its economy, but its ability to function as a democratic nation. And it’s hard to see when or how that wrongness will get fixed."

NGDP targeting proponents seem to argue that agents want to instead avoid transfers of wealth stemming from unexpected NGDP (not just price level) deviations from trend. By restoring NGDP to trend, targeting avoids the deadweight loss from having to restructure credit contracts.

The above, to my mind, cuts against the nature of risk in capital investment. Investors accept credit (income volatility) risk ex ante; in return, they receive a risk premium above government debt returns. In your model, a promise to eliminate that risk results in transfers of wealth from bondholders to investors each time incomes fall below trend. In a highly credible NGDP targeting regime, the ex ante risk premium would practically disappear without the Fed needing to actually effect those transfers.

What are the implications of a near-zero cyclical credit risk premium? First, system-wide leverage would spike as actors abandoned insurance (capital cushions). The resulting systemic risk would create a fragile financial system, one vulnerable to adverse feedback loops in the face of even small real shocks. Second, arbitrageurs would earn economic rent if they acted on the credibility of the Fed's promise before others did. Third, the economy would suffer from over- or mal- investment, likely concentrated in sectors most affected by Fed stabilization policy. Arguably, all three dynamics fit with the facts of the Great Moderation and its GFC aftermath.

Can you expand on what you want the theory of debt to do? Would it be lending from old to young for whatever purpose the young might have? They could then consume or invest more? That could be a very fruitful expansion.

Yes, precisely. I am presuming that debt is an institution that plays a welfare-enhancing role in allocating resources efficiently (constraineed-efficient) from an ex ante perspective. Modeling the source of the frictions that makes debt essential seems like a necessary step, if one is to ask how policy intervention is likely to influence resource allocation for better or worse.

-Investment demand is a function not only of expected returns but also their expected volatility.-The expected volatility of returns is partially a function of the expected availability of credit.-The expected availability of credit is partially a function of the expected volatility of returns.

A (pro-cyclical) feedback loop results. Because the availability of credit is also a discontinuous function of credit levels (leverage), this procyclicality has a built-in reversal mechanism.

A model based around news shocks makes for a very good description of the 1990s data, but few people really found any fault with the way the Fed operated monetary policy in the 1990s. These are relatively small shocks that can be easily accommodated with a taylor-type rule that places a sufficiently high weight on inflation. By contrast to the 1990s-style investment-driven business cycle, the Great Recession involved actual consumption demand, which calls for a different kind of shock in the model.

The (alleged) need for an NGDP target comes from the presence of a zero lower bound and the possibility for large and persistent enough demand shocks (ie, not news shocks) to force the interest rate down to the zero lower bound for an extended period of time. In this environment, the fed can only raise output if it can credibly commit to higher inflation (which affects output by way of nominal price rigidities). The NGDP target just formalizes the idea that in the New Keynesian framework with a zero lower bound, we want inflation to be highest when output is well below the efficient level.

A constant price level target would minimize the costs associated with inflation, but also maximize the chances of being stuck at the zero lower bound (with interest rates well above market clearing), and doesn't respond to welfare-reducing aggregate demand shocks.

Note that there is a zero lower bound in my model as well. Moreover, the Fed can increase output by promising higher inflation (it will need the help of the Treasury to do this if the economy is at the zero lower bound, but it's still possible).

And yet, despite these properties, the NGDP target is not a good idea. But perhaps the answer will be different if I consider a "liquidity shock" instead -- similar to what I have done here:

In my view one needs a sticky wage assumption to create models consistent with the stylized facts. It's hard to identify monetary shocks, but the most severe negative demand shocks (1921, 1930-31, 2009, etc) seem associated with large jumps in real wages and large declines in hours worked. I can't see how that can be modelled unless one assumes sticky nominal wages. Otherwise how can one explain what's going on in the labor market?

If you don't insist that those shocks are "demand" shocks, which of course is not a useful classification, then shocks to the labor supply of agents works just fine to accommodate a simultaneous rise in wages and a decline in hours. It is only your blind adherence to AD/AS type nonsense that keeps you from understanding that point.

What exactly the shock to the labor supply equation was is another issue, but one that nominal wage stickiness has importance for.

I like to organize my thinking about the labor market according to models of labor market search. In such models, it is not clear that the nominal spot wage matters for anything; what is important is how the present value of the joint surplus is divided over the life of the relationship. I talk about this at some length here: http://andolfatto.blogspot.ca/2010/07/sticky-price-hypothesis-critique.html

How to understand current labor market dynamics without sticky nominal wages? Interpret the k in my model above as "employment capital." Firms must make investment in search and recruiting that yield a future payoff (profitable employment relationships). If firms are pessimistic about the return to forming such relationships, they will economize on recruiting activities. (Whether or not the nominal wage is sticky).

Just out of curiosity, are you suggesting that sticky nominal wages is critical to your advocacy of NGDP targeting? Please point me to one or two (of your several thousand posts!) to help me along here. Thanks!

In your linked post on sticky prices you acknowledge that prices may empirically seem to be sticky, but downplay whether that matters. The fact that they are sticky, though one might not ordinarily predict that from first economic principals, can be an indication that something strange is going on. The nominal effect at zero I mentioned helps explain why monetary policy can have real effects. Scott Sumner has another graph showing inverse detrended real wages vs industrial output during the great depression (the original post has broken images, this is the next best I can find), and can point to monetary shocks like Roosevelt devaluing the dollar. Nowadays markets tend to rally when the Fed indicates that it will ease (David Glasner has done work on the recent aberrant correlation of the market with inflation), because "markets are market monetarists".

Wonks: In a durable relationship, the time path of real or nominal wages is largely indeterminate (there are an infinite number of ways to split the present value of the joint surplus). That graph tells me nothing. It would tell me something if I believe that labor was hired on an anonymous spot market. But we know that labor markets do not work this way: they are relationship markets.

Marshall's scissors were nonsense anyway - supply is no less subjective than demand.

Wonks: Markets rally when the Fed indicates it will ease because investors are gloriously dedicated Keynesians. For the most part. While that's true, I'm being a tad hyperbolic. If one notes the CAPM, APT, or really any factor model, the first factor determining the return on an equity (or bond, for that matter) is the risk-free rate of interest. When the Fed takes steps to drive down the risk-free rate (or keep it low) then the required return on equities gets driven down (or stays down).

Now, I realize only about 50% of the changes to equity prices are driven by macro factors, and the other 50% is noise, but we don't need complicated arguments to know why stock markets (heart) the Fed's 'easing.'

Its a shocking news to why NGDP target in an overlapping generations model but its good that its model have a problem so (josh)nice to provide reason to why an NGDP target is a good policy prescription. Overlapping generations model is a one type of the economic model. SO We can easily create a economy model.

David,Try "The Two Fundamental Welfare Principles of Monetary Economics" by David Eagle. Here is an excerpt:

"What this has shown is that the proportionality of the real value of the loan payment, which is needed for the Pareto-efficient sharing of RGDP risk for people with average relative risk aversion, happens naturally with nominal fixed-payment loans under successful NGDP targeting. When RGDP decreases (increases) while NGDP remains as expected by successful NGDP targeting, the price level increases (decreases), which decreases (increases) the real value of the nominal payment by the same percentage by which RGDP decreases (increases).

The natural ability of nominal contracts (under successful NGDP targeting) to appropriately distribute the RGDP risk for people with average relative risk aversion pertains not just to nominal loan contracts, but to any prearranged nominal contract including nominal wage contracts. However, inflation targeting and price-level targeting will circumvent the nominal contract’s ability to appropriate distribute this RGDP risk by making the real value constant rather than varying proportionately with RGDP."

for people who have locked in their price and quantity of capital well in advance (which is most people: for the largest piece of capital most people own, housing, the price is locked in for 30 years), they cannot easily renegotiate it to adjust their consumption. also, the adjustment process is assymetric, with a cost. i can/will abrogate debts if the price goes down below replacement cost plus regegotiation costs. Conversely, if the price goes up, the loan does not get renegotiated.

1. I approach this from a different angle. I view labor markets out of equilibrium as the key stylized fact to be explained (not fluctuations in RGDP.) An obvious possibility is that wages are above market equilibrium.

2. With have all sorts of empirical evidence that nominal wages rates are really sticky, and also that there is money illusion near the zero percent wage increase point.

3. In almost any macro model that can be imagined (including any model "organized around search," to use your terms), if nominal wages are sticky, then a tight money policy that reduces NGDP will increase the ratio of nominal hourly wages to NGDP, and reduce hours worked. That reduction will look "involuntary" to casual observers (although I concede "involuntary unemployment" is not a useful term for economists.)

4. We have evidence that negative NGDP shocks cause some unemployment when wage markets are laissez-aire, and also that they cause even more unemployment when wages are made less flexible by government policy.

5. We have evidence that exogenous monetary shocks impact NGDP.

In my view that collection of facts points to a very natural and obvious explanation for what's called "demand-side business cycles," that is those that don't seem related to any obvious real factors like natural disasters or destructive government policies, but do seem related to a fall in nominal spending. There are competing models, such as RBC models, but they don't strike me as being as consistent with this set of facts, nor do they seem as plausible to me.

I don't start with the sort of highly technical GE models used by modern macroeconomists, because I see no evidence that those models are useful for explaining demand side business cycles. And I studied macro under Lucas, so I have some familiarity with these models, although admittedly I'm far behind where you are. Nobody's ever explained these models in a way that's persuaded me that I should get up to speed on the subject. Obviously it's possible I'm making a horrible mistake, but here's why I am resistent. I believe my approach to macro can provide a very simple and powerful explanation for what happened over the past 4 years. I see much better economists than me floundering around trying to invent brand new models to explain the recent recession, models based on "debt", when the NGDP shock model does just fine. If it ain't broke, why fix it?

Scott, I appreciate your reply. My quick response to some of the points you make.

1. I think fluctuations in the labor market are important too (my PhD thesis devoted a chapter to the subject). But whether the labor market is "in equilibrium" or not is a matter of interpretation. Do you mean Walrasian equilibrium? Search equilibrium? Competitive search equilibrium? There are different notions of "equilibrium" out there. I'm not sure why one should remain wedded to the conventional notion of "competitive spot market equilibrium" (the Marshallian scissors).

This is important because if search models can explain employment/unemployment, the policy recommendations suggested by this class of models may (or may not) differ dramatically from prescriptions that are based on "disequilibrium" models. I think it is important for researchers such as ourselves to be aware of this possibility and to therefore temper our enthusiasm for making strong policy recommendations.

2. The evidence you cite here may not be relevant for search equilibria where agents form lasting relationships. In other words, I can build search equilibria that have nominal price rigidity, but where the spot wage is not "allocative" (what matters is the time path of the wage throughout the duration of the match.)

3. Your statement 3 sounds like a proposition in search of a proof. Can you supply me with the proof? (Especially for the search equilibrium case).

4. I would like to see this evidence. Can you give me a reference or two?

****

I don't think it necessary for *everyone* in the profession to take one particular approach to a problem. I see your less technical approach as a complement to the more formal approaches that others take. As for myself, I am convinced that there exists a way to formalize your argument in a language that I am familiar with. The formalization, if it exists, will make clear the set of critical assumptions that underlie the argument. This is an essential step in the scientific process, imo.

The type of model that you use in the paper in the St. Louis Fed Review is more consistent with what I am referencing. Nonetheless, I still see two issues of separation in our thinking.

1. The difference between OLG models and Lagos-Wright search models seems important. In the LW model, money serves as a medium of exchange. As such with multiple transaction assets, it is the total stock of liquidity that matters. In the OLG model, the liquidity shock results in a credit crisis. This is different from the liquidity shock in the LW model and the reason is because money and other assets are stores of value in the OLG model and not media of exchange. This distinction is important as it suggests that in the LW model stabilizing the supply of liquidity is welfare-increasing. A second-best policy (as defined in the post above) is one that stabilizes nominal GDP. A first-best policy is one of constant money growth — the Friedman rule or a positive rate of growth if there are distributional effects. It is not clear that this is true in the OLG model for the reason mentioned above.

2. You suggest that it might be hard to distinguish between a bad news shock and a liquidity shock. This is certainly true of these two models. However, the empirical evidence on news shocks seems to be at odds with your model. For example, in your model, a good news shock causes an decrease in real money demand. Holding the money supply constant, this implies that price level should rise. However, empirical evidence on news shocks seem to suggest that the price level falls following a good news shock. See for example, Barsky and Sims:

I often hear people say that "money is a store of value in OLG models, and not a medium of exchange."

That statement is false in the sense that the role of money in OLG is precisely the role that money plays in LW: it is substituting for a missing record-keeping technology.

So, I believe your point 1 is completely off-base. We can talk about this some more via email if you'd like. Having said this, there may indeed be something missing from the OLG and LW models that need to be incorporated.

Your second point seems to me to be a more valid objection. Of course, those authors focus on news defined over future technology shocks. I like to think of news as pertaining to anything that influences the expected return to investment (including the likely path of future tax rates). I will have a closer look at the Barsky and Sims paper.

How does one distinguish between, as regards technology, what is good news and bad news (and over what period of time)?

To be clear, we all know that with a reasonable period (20 and 50 years, est.) there will be little or no work building or making things. Robots that build and repair themselves will build or make everything, forcing us to face Mark Twain's Hell on Earth.

For example, a robot or robots will dig up a current highway in need of replacement, recycle its materials, and lay a new highway as mammoth machines, worthy of Star Wars, inch forward.

Now, this is as "real" as having to pay taxes in 30 years on current borrowings. If one says the expectation of having to pay taxes matters, then so too much the expectation about technology "news."

In sum, we already have the answers. It's a confidence game, nothing more (or less). We should be asking ourselves, only, what policies, today, will give our people the most confidence.

I agree that to a large extent, it is a confidence "game." Policies should engender confidence that people can reap the rewards of their investments. Of course, one should like to hope that such confidence is justified (and the rug will not unexpectedly be pulled from underneath us.)

You write, "Policies should engender confidence that people can reap the rewards of their investments."

I have to ask, Do you include what people pay or agree to pay for their homes, when you write about "investment"?

I believe you would agree that the Fed unexpectedly pulled that from underneath us all.

And, my two cents, you can write all you want about NGDP, Taylor Rule, whatever. It is all what I call Frankfurt Bullshit to the average homeowner who has lost 40%+ of their net worth, notwithstanding the stock market's return.

To the average American, the Fed pulled out the rug and since having done such has done absolutely nothing but worry about the Big Boys, destroying confidence.

Under the circumstances, it seems to me that you have to agree that the cynicism of the populace is amply justified.

While you have written many interesting things, and I have tried to mention when you have noticed important papers---the one on oil shocks and a stagnant and aging population is a must must read---do you have any expectation that your thinking or writing will ever trickle down to the average American homeowner?

Stop for one second and take enough steps back from economics until you see the picture that I see. You are so close that you cannot see the forest for the trees.

If you had my altitude and perspective it is as plain as day that macroeconomics is more a religion or cult than a science.

Thoma just stated this simple true for the Financial Times:

Macroeconomic models have not fared well in recent years – the models didn’t predict the financial crisis and gave little guidance to policymakers, and I was anxious to hear the laureates discuss what macroeconomists need to do to fix them. So I found the lack of consensus on what caused the crisis distressing. If the very best economists in the profession cannot come to anything close to agreement about why the crisis happened almost four years after the recession began, how can we possibly address the problems?

Read what you, SW, and the right wing from Cochrane to Prescott write and say.

What would be your diagnosis?

It is plan as day that SW, you and all those describe by Krugman have cognitive dissonance. It's a simple diagnosis, straight out of Dr. Robert B. Cialdini's Influence and his discussion of the Chicago doomsday cult. I live, day-to-day, in a profession that is in worse shape.

Second, I am not cynical. I am a realist, totally fact based. Any strong undergraduate economist can read the papers, papers which you have put up, and see that we are totally, absolutely, and completely screwed. It is over for the United States. Economics is path dependent. There are two forces destroying this country and nothing, not NGDP, not the Taylor rule, not Krugman's printing press is going to prevail over those forces in the long run. The first force is demographic: our decline in population numbers and aging population. You have read the papers. Second, there is globalization, which has destroyed all the good jobs in America. We are going to be finished off by location theory.

"But now that many categories of high tech have moved virtually all production offshore, companies are finding that they also need to move more and more of engineering and design work overseas as well."

Munger long ago in his famous speech warned economists that they were men with hammers for whom the future would turn out badly. Have you read and deeply considered his essay, The Psychology of Human Misjudgment?

What best describes SW and you. You are people who have drank the cool aid. You are doubling down on what you believe, exactly the way the Chicago cult behaved.

Who is Krugman? He is a Protestant Reformation speaker, attempting to get you to reform.

Missouri has produced two great thinkers. I doubt you are familiar with either, but you should be. Truman lived by the rule that human nature never changes, his wisdom being something like the following:

"The only thing new in the world is history you don't know." This is true, Truman maintained, because human nature never changes and whatever people did 100 years ago or 50 years ago is what they'll do today."

Krugman and many others keep saying, "We are reliving the 1930s." They are right. You are wrong.

John D (or whatever your name is). I want to thank you for your contributions, but can you please stay on topic? This is not about who's right or who's wrong. I want to have a discussion about NGDP targeting. Thank you.

The Keynesian line is nonsense. It was in 1936, and it is now. We are reliving the 1930s in the following way: the Federal government keeps interfering with the healing process. But that's not the story you want to push here, Anon.

What David (and many, many others) are doing is asking good questions that don't have easy answers. This is scholarship in economics - not the natural sciences.

Easy answers don't work and usually have consequences that are far worse than any possible benefit they might have. This we know from economic history - which is held in books, not blogs. Get to readin', boyo, before you get to talking smack. That's a tall order for blog commenters, but such is life. If you want to make a value-added contribution to a thoughtful discussion, it's going to take the exercise of the intellect.

1) I have read, far far too much, and the most sensible comments I have found have been, albeit too infrequent, right here or at Noah Opinion.

The paper up here a few days ago on oil price shocks, aging population, etc. was powerful, deeply disturbing evidence.

2) Modern economies are not self-healing. If they were, Bush's policies would not have resulted in the Depression we have been in since 2006. We had, least you forget, tax cuts and deregulation and ended up in a Depression.

3) My two cents, Keynes was right and Krugman is wrong: Keynes presented his ideas in a way that matched the needs of people for leadership, confidence, and vision. Krugman doesn't.

I am very interested in the NGDP issue. I believe it is fundamentally flawed because it doesn't meet the Soros test: irrational people with imperfect information are going to alter their behavior based on expectations about the rule. No one has explained how the "rule" or whatever term one wants to use, rises to meet this unexpected and unknown (perhaps) behavior.

In sum, I believe the problems are deeper, more complex, and far more urgent than either David or the people, like you, commenting here.

And, David might want to ask advocates of NGDP targeting to consider Minsky's suggestion, that "Indexing as a mechanical device in social security and government pensions should be abolished, so that inflation leads to a substantial budget surplus."

I've read Minsky, and I've read Kindleberger and Aliber that hang their whole story on "Minskey moments." What it left me with was a profound sense of something missing. Minsky moments are these ephemeral instances where everyone suddenly switches from optimism to pessimism. Nothing more than an invocation of animal spirits, really. Well, that's not enough to make a proper theory.

You don't the first thing about building a science. To build a science, as Feynman well explained, you first need a guess, but not just any kind of guess. You need a guess that is consistent with all known facts and observations. Minsky's work meets that test, unlike Hayek, etc., is thus is scientific (as is Keynes).

"The paradigm that the market corrects itself, on which all the traditional economists such as Blanchard and Mankiw base their theories, is on the rocks," said Gatti. "What the traditional theories do not consider is that the financial market must be regulated. A too-liberalised market creates monsters."

And, I can now happily report that the best paper now available on economics was written by a lawyer, like myself.

Of Mises and Min(Sky): Libertarian and Liberal Responses to Financial Crises Past and Present

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1871285

I especially like this observation about the intellectual dishonesty of libertarians

While not possible to take seriously as a practical policy proposal,Rothbard’s case against the banks is a telling moment in Austrian business cycle theory. Its very implausibility, almost silliness, and its deepinconsistency with the libertarian thrust of most of that theory, is revealing. An intelligent and usually rigorously consistent theorist like Rothbard is likely to fall into such a trap only when there is a deep hole within that theory, a tension between competing principles that the theory finds impossible to resolve convincingly. Although Rothbard in many places follows the Panglossian response, when he attacks private banks he is recognizing a deep fragility within the market system. As much as possible he tries to blame that fragility on central banks and regulation, buthere he more honestly confronts the dilemma of a libertarian approach to business cycles and the financial markets. But his intellectual honestyfalters in his lack of serious scrutiny of his proposed solution.

"Stabilizing nominal GNP is not a desirable goal in and of itself; instead, it is desirable because of its impiications for stabilizing output at the full information level. In this sense, nominal GNP targeting actually represents an intermediatetarget” of policy. An intermediate target is one that is adopted because, by achieving it, one also achieves the ultimate policy goals."

"Thus, even within an aggregate demand supplyframework, different underlying assumptionsabout how the labor market operates willproduce different evaluations of the relativeusefulness of alternative policy rules. Untileconomists can agree on a model that reasonablyexplains changes in the state of theeconomy, it is difficult to take the policy recommendations from any particular model veryseriously.... Consequently, while the theoretical model outlined earlier in this paper strongly supports the usefulness of nominal GNP targeting, a similar model that differs only in theunderlying assumptions about the labor marketsuggests that price level targeting is superior tonominal GNP targeting."

in other words, regardless of the model, it comes down to whether you agree with the assumptions.

my only point about this is that i think ngdp dominates price level targeting when we cannot agree on the underlying assumptions. And the cost of adopting NGDPLT in a realistic model where PLT is optimal but the policymaker adopts NGDPLT are very low at low levels of inflation (2-3%).

1. like Carly Rae Jepsen's "Call Me Maybe," the term "bubble" is saccharin, totally overplayed, and has zero meaning. what is the technical definition of a bubble? How do i tell the difference between a bubble and people rationally responding to financing incentives created by poor lending standards (which themselves are due to poor regulatory guidelines)?

2. supposing for a second psychological bubbles actually exist, it sounds to me as though these are outside the bounds of what monetary policy can fix. maybe we should be prescribing Zoloft for all market participants as the proper supply side response?

As to the comment, "He asserted it, but provided no evidence." Well, the winner is that category, for sure, is Hayek.

For the record, Stiglitz provide evidence, but regardless, his observations are certainly good science under Feynman's test posted a few days ago here.

As for psychological bubbles being outside monetary policy, dwb, its seems to me that question is very premature. First, we need a macro economics that is based on real world facts and psychology. Only then can we ascertain what can and cannot be done.

"As for psychological bubbles being outside monetary policy, dwb, its seems to me that question is very premature."

i was poking fun at your use of the term psychological bubbles, sarcasm, especially my very dry form, can be ahrd to decypher. I have a book on my desk "the hour between dog and wolf" written by a trader turned neuroscientist, which i am looking forward to since i have biology and economics training myself.

no, my point is that while i think *some* people behave irrationally, i am strongly skeptical of "animal spirits" and mass hysteria. Humans may be irrational and emotional, but economics is the science of bringing incentives to bear to effect aggregate behavior. If aggregate behavior is "wrong," (whatever that means) then the incentives are "wrong."

I doubt monetary policy is the factor since it affects all industries, and we only observed misaligned behavior in select industries, like bank lending. Since i also observe a lot of moral hazard in bank lending and a lot of misaligned incentives (managers and originators incented to make a quick buck rather than look at actual long term credit risk), i dont think its psychology at all, or more aptly, incentives that were designed to reward short term risky behavior at other peoples expense.

Breaking News: Nouriel Roubini has stated that, next year, we can disband the Fed, for it will have fiddled so long it will no longer be useful and David can return to something productive (hanging dry wall again in Canada?)

In disbanding the Fed, President Romney will be relying on his two principal economic advisers, Ron Paul and Nassim Nicholas Taleb.

A post for the ages is found on Taleb's Facebook page, where he wrote on March 9th:

Starting to campaign in support of Ron Paul: fundraiser March 20 in LA., TV next Tuesday 11 am. Out of duty. Two events, then back to the silence of the library.

http://www.facebook.com/pages/Nassim-Nicholas-Taleb/13012333374

Inquiring minds want to know why Taleb flew over the Oracles of St. Louis (David and SW)? Doesn't their mojo work any more?

In the meantime, may be David should take a leave of absence and volunteer to do more useful intellectual work, such as going to Italy and Greece and searching for the lost "Sack of Ilium", also known as The Sack of Troy, which Nero recited while Rome burned.

America's best economist:

Raekwon the Chef, Method Man

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I made up my mind recently to change my policy and start removing comments that did not contribute to the debate. Yours certainly falls into that category, but I'm leaving it up because it's just too entertaining.

You really need to watch the IMan, Don Imus. If you did you would know useful stuff about economics, like the 5 favorite songs of Nouriel Roubini

“Forever Young,” by Jay-Z “Almost Gone,” by Kelly Clarkson “Knock You Down,” by Heri Hilson “Jurado,” by Emily Palame “Empire State of Mind,” by Jay-Z ﻿http://www.imus.com/five-favs/category/dr-nouriel-roubini

In terms of a career path you might want to consider.

First, writing something worthwhile enough to get an invite to a table at Rao's

Second, being funny enough to get on IMan

Third, knowing enough about music to understand that at the zero bound, Raekwon the Chef, Method Man is as good as any other economist, for then the only rule that matter is: C.R.E.A.M

BTW, did you see the silly Spaniard, an Austrian, trying to lecture Krugman? Krugman made him into a fool by pointing out that 10 year treasuries were at 1.54%. CNBC had a fool on this morning who wanted the Fed to raise rates, so that savers would have incentives to save.

Applying CREAM, today was the last day for CNBC at our household. The Mayor's Channel (of the City of New York) is free on the Internet and at least ran, real time, the hearings on Diamond, et al.

Have you been up watching those, or do you still work on theoretical as opposed to fact based macro economics and finance?

I mean why do you bother with NGDP targeting when no one over 30 is ever going to buy a new shirt, all out of fear over the coming cuts in Medicare and Social Security?

Just to stay on topic, Hows does targeting NGDP play into the paradox of thrift?

This morning we pose the Keen question about NGDP targeting. What will happen to aggregate debt, public debt, and private debt?

In asking, we recall:

"The statistics we report are of interest, given neoclassicalgrowth theory, because they are-or maybe were-in apparent conflict with that theory. Documenting real or apparent systematic deviations from theory is a legitimate activity in the natural sciences and should be so in economics as well.

* * *

"The fact that the transaction component of real cash balances (M 1) moves contemporaneously with the cycle while the much larger nontransaction component (M2) leads the cycle suggests that credit arrangements could play a significant role in future business cycle theory. Introducing money and credit into growththeory in a way that accounts for the cyclical behavior of monetary as well as real aflgregates is an important open problem in economics."

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